Taylors Rule

A general rule for central banks when deciding interest rates. The rule states that interest rates should be increased in times of high inflation and when employment is higher than full employment, and should be decreased in periods of low inflations and higher unemployment. The rule states that following these principles will encourage growth while discouraging inflation. The Federal Reserve follows this rule implicitly, even though it does not explicitly endorse it.

GDP, then the Federal Fund Rate should be raised by 0.5%. If inflation rises 1% above its target rate of 2%, then the Federal Fund Rate should be raised 0.5%. This rule has been suggested as one that could be adopted by other central banks, such as the EUROPEAN CENTRAL BANK and the MONETARY POLICY COMMITTEE of the Bank of England, for setting official interest rates.

However, the rule does embody an arbitrary 2% inflation target rather than, say, 3% or 4%, and it may need to be amended to embody alternative inflation targets at different times or by different central banks. The advantages of having such an explicit interest rate rule is that its very transparency can create better conditions for business decisions and can help to shape business people's and consumers’ expectations.

We (8) show that the Taylor-rule model, when expressed as a present value relationship, has a modest positive correlation with the actual real dollar/DM rate over the 1979-98 period.

12) As noted above, Taylor-rule models imply that a country's currency will appreciate when there is news of higher inflation.

And, there is some favorable evidence: exchange rates contain news about future fundamentals; they are not so excessively volatile as the literature once accepted; Taylor-rule models show some promise; and, exchange rates respond to news in the way the models predict.

In particular, I use inflation and output data to estimate a baseline Taylor-rule specification for policy and test whether the bias statement provides any additional information for forecasting changes in the FOMC's Federal funds rate target.

The information content in the bias statement has been a statistically significant factor for predicting changes in the funds rate target over the sample period, even after controlling for responses to policy variables in the Taylor-rule equation.

Arguably, then, the clear departure of the Fed funds rate from the Taylor-rule during those years might plausibly be accounted for in terms of an adjustment by the Greenspan Fed for an exceedingly low natural rate.

One is its emphasis on the difficulty of measuring the "output gap" variable that appears m price-adjustment and Taylor-rule equations, that is, the percentage difference between current output and its "potential" or "natural-rate" value.

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